Ackman to regulators: Let bond insurers fail

A worker takes a measurement on a new house under construction in the Green Valley Ranch development in Denver, Colorado July 26, 2007. Bill Ackman, whose hedge fund has been betting against bond insurers since at least 2002, said in a letter to U.S. regulators that rescuing the bond insurers will only prolong the credit crisis, and the companies should instead be allowed to fail.

NEW YORK (Reuters) - Bill Ackman, whose hedge fund has been betting against bond insurers since at least 2002, said in a letter to U.S. regulators that rescuing the bond insurers will only prolong the credit crisis, and the insurers' holding companies should instead be allowed to fail.

In the letter, obtained by Reuters, Ackman said bond insurers in recent years have become a means for banks to avoid reporting their full credit exposure and make their capital ratios appear stronger, but that banks should be forced to own up to their full credit risk.

"(W)e understand that the banking industry counterparties to the bond insurers would prefer to avoid taking these ... risks back on balance sheet -- particularly at a time when their balance sheets are strained by subprime and other losses that have not been hedged," Ackman wrote, adding that "there are no such free lunches available in the capital markets."

Bond insurers have in turn been critical of Ackman and other investors betting against the companies. On a recent conference call, MBIA Inc (MBI.N) Chief Executive Gary Dunton railed against "the fear mongering and intentional distortions of facts about our business that have been pumped into the market by self-interested parties."

The fact that Ackman has been arguing against the bond insurers so vociferously has made at least one investor consider buying bond insurer shares.

"If (Ackman) is certain the bond insurers are worth zero, why does he have to lobby so much?" said William Smith, chief executive of Smith Asset Management, which manages about $70 million.

"He's not writing these letters out of the goodness of his heart -- he has a position," Smith added.

MBIA shares rose 14 cents to $14.42 in early afternoon trading on the New York Stock Exchange, a day after the company announced plans to raise at least $750 million of capital.

New York State Superintendent Eric Dinallo is working with banks to rescue bond insurers including Ambac Financial Group Inc ABK.N and FGIC Corp, which face billions of dollars of potential losses after guaranteeing bonds linked to risky subprime mortgages and other debt.

One idea floated by Dinallo early in discussions was banks putting up a rescue fund of about $15 billion to save the insurers, according to a person briefed on the matter. That idea has now given way to separate rescues of the companies, which collectively guarantee more than $2.4 trillion of bonds.

HOW MUCH CAPITAL IS ENOUGH?

But some analysts argue a rescue will take a lot more than $15 billion. Sean Egan, managing director of independent credit rating firm Egan-Jones Ratings Inc, says the top six bond insurers face roughly $80 billion of eventual losses, and probably need more than $200 billion of new capital.

Ackman said in his 13-page letter that given the eventual losses the bond insurers face, banks that have traded with the companies should write down their exposure today and raise enough new capital so they can continue to operate safely.

Banks and bond insurers should be forced to disclose their exposure to repackaged bonds and loans known as collateralized debt obligations immediately, Ackman added in the letter, which was addressed to Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson and others.

Regulators should step in to take steps to preserve capital at the operating units of bond insurers, Ackman wrote.

Any transactions between the insurers' holding companies and the operating units should be examined carefully, Ackman said. Dividends from operating units to their holding companies -- which are used to pay dividends to shareholders, among other uses -- should be suspended, Ackman wrote.

Ackman is founder of Pershing Square Capital Management, which has sold shares of Ambac and MBIA short in a bet they will decline. Pershing Square manages some $6 billion. In addition to these short positions, the company also buys shares of companies and agitates for change, as at McDonald's Corp (MCD.N) and Wendy's International Inc WEN.N.

THE INSURERS' CASSANDRA

Investors for years ignored bearish analysts like Ackman, and instead sent shares of bond insurers like Ambac and MBIA Inc to record levels as recently as the beginning of 2007.

But market participants have become much more open to Ackman's arguments in recent months as bond insurers have reported billions of dollars of payouts, posted quarterly losses that eroded a substantial portion of their net worth, and edged closer to losing top ratings crucial for their business.

If U.S. bond insurers lose their top ratings, global financial markets could be hurt. Investors that can only hold top-rated bonds will be forced to sell them, while banks will be forced to record losses that some analysts estimate at $70 billion or more.

Bond insurers originally focused on guaranteeing municipal bonds against default. Tax-free bonds issued by cities, states, and other government entities rarely default.

But in the last decade, the insurers have sought higher returns by guaranteeing repackaged subprime mortgages and other risky assets against default. That turned out to be a losing bet after housing prices stopped rising, borrower defaults jumped and credit markets went into a tailspin.

To download Ackman's letter, please double click here: here

(Editing by Brian Moss and Steve Orlofsky)